The essential concept of partnership taxation is that all profits and losses flow through to the partners in the business, who are then responsible for these amounts. Thus, the business entity does not pay income taxes. A partnership is considered to be an arrangement where at least two people are engaged in business without sheltering behind a corporate entity.

The Partnership Agreement

A partnership agreement is used to document the details of a partnership arrangement. It commonly includes the following items:

The ownership percentage assigned to each partner. If this is not clearly stated in the agreement, then the ownership percentage is considered to be based on the proportions of capital paid into the partnership. If there is a change in ownership during the tax year, then the average share must be calculated for each owner for tax purposes, though this can be overridden by other terms in the agreement.

The situations in which the partners can buy out another partner, and how the payment is to be calculated and made.

The amounts of any preferential payments to certain partners.

Partnership Taxation

The primary tax form filed by a partnership is the Form 1065. This form notes the amount of taxable income generated by the partnership, and the amount of this income attributable to each of the partners. In addition, the partnership issues a Schedule K-1 to each of the partners, on which is stated the amount of partnership income attributed to them, and which they should include on their own personal income tax returns.

Because partners must pay income taxes on their shares of partnership income, they typically require some distribution of cash from the partnership in order to pay their taxes. If a partner elects to instead leave some portion of his or her share of a distribution in the partnership, this is considered an incremental increase in the capital contribution of that person to the business.

In those instances where a partnership recognizes a loss during its fiscal year, the share of the loss recognized by each partner in his or her personal tax return is limited to the amount of the loss that offsets each partner's basis in the partnership. If the amount of the loss is greater than this basis, the excess amount must be carried forward into a future period, where it can hopefully be offset against the future profits of the partnership. In essence, tax law does not allow a partner to recognize more on his or her tax return than the amount contributed into a partnership.

A partner is required to make quarterly estimated income tax payments. This payment can be the lesser of 90% of the partnership's expected annual income, or 100% of the actual tax paid in the immediately preceding year.

A final tax issue is that partners are not considered to be employees of a partnership, and so must remit the full amount of the self-employment tax.

Partnership Elections

The partners in a partnership can make several elections that can impact the amount of taxable income recognized by the partnership, because they alter the timing of either revenue or expense recognition. These elections are:

Record transactions under either the cash, accrual, or hybrid methods of accounting